Published February 7th, 2017 by Nick McCullum
Dividend growth investing is an actionable, repeatable way to build wealth over the long term.
One of the most common goals of the dividend investor is to create a large enough dividend income stream to comfortably retire.
This begs the question – exactly how much money does one need to retire? How much should be contributed each year to reach this sum? How much more should be contributed if one wants to retire X years early?
On the surface, these questions might seem impossible to answer. Each question contains so many variables that they are difficult to answer with any certainty.
However, that does not stop an investor from making informed estimations. With the right data and proper tools, investors can make reasonable predictions about future retirement scenarios.
More importantly, they can use these predictions to make adjustments if they are not on track to meet their goals.
This article will provide a useful tool to aid in retirement planning and discuss some of the qualitative and quantitative aspects of retirement forecasting that are within investors’ control.
Introducing the Sure Dividend Retirement Calculator
The tool that will be introduced in this article was designed to help investors calculate the expected value of their retirement portfolio when provided with certain personalized variables.
The most rigorous way to do this is by using a Monte Carlo simulator. This is a statistical technique that runs multiple simulation of future investment returns based on previous stock market behavior.
With the right software, an investor can run 10, 100, or even 1000 simulations, giving them a range of expectations for the future value of their retirement portfolio.
The Sure Dividend Retirement Calculator is a 100-simulation Monte Carlo program that bases its expected returns on the behavior of the Vanguard Dividend Appreciation ETF (VIG) since the fund’s inception in 2006. With its focus on dividend stocks, VIG was selected as a reasonable benchmark for Sure Dividend readers.
You can access the Sure Dividend Retirement Calculator at the following link:
Like any other statistical calculator, the Sure Dividend Retirement Calculator makes various assumptions that may or may not be realistic depending on market behaviors.
One of the most notable is the assumption that stock market returns are normally distributed. This is statistical language that says that the stock market behaves according to a particular mathematical distribution.
Namely, saying that returns are normally distributed implies that they are centered around some mean with a bell-curve shape, like this:
In reality, the probability distribution of stock market returns is much more skewed towards the tails of the above graph. In other words, extremely outliers are observed more often in stock market returns than would be expected from looking at the chart above.
An example of this can be seen in the following illustration.
Source: JP Morgan Asset Management
While the observed (or empirical) stock market returns have a higher center points than the corresponding normal distribution, this is offset by a ‘fat’ left tail due to a higher-than-predicted number of extremely negative occurrences.
That being said, the normal distribution is commonly accepted proxy for stock market returns. The Sure Dividend Retirement Calculator makes use of a normal distribution based on the historical data available from VIG.
Other Considerations for Retirement Planning
While having a calculator to compute the value of one’s retirement portfolio is certainly quite helpful, many investors will still have questions about the variables involved in their retirement planning.
There are many factors that are not able to be explained by math. For instance, the decision of when an investor will retire.
The rest of this article will be devoted to some of the factors that investors must keep in mind when planning for retirement.
In the Sure Dividend Retirement Calculator, annual contributions are one of the user-selected variables. This means that investors have to estimate for themselves how much they will be capable of contributing each year.
There are a variety of factors that play into an individual’s ability to contribute to their retirement portfolio. The largest is net income. A higher wage will result in larger retirement contributions, all else being equal.
This post is not about how to maximize income. Rather, it is about how to determine the proper proportion of one’s income to devote to retirement savings.
Before diving into one tip on how to decide on a retirement contribution, I wanted to present some data on the average size of retirement accounts in the U.S. over time.
The following diagram presents the data succinctly.
Source: CNBC, EPI
The results are striking.
In 2013 (the most recent data point on the chart), the mean retirement savings for all families was $95,776. This doesn’t seem so bad when considering how many young families would play into the calculation of this figure.
However, numbers like retirement savings are often poorly represented with a mean, since there are large outliers that will skew the average up. Since the lower bound is zero, a large outlier of $10 million will have much more effect than the smallest possible number (0).
This is why it’s better to interpret retirement savings via the median – the middle point of the data set. Looking at the chart above, the median retirement savings of all families is $5,000, which is noticeably different from the median figure of families with retirement savings ($60,000).
This suggests that there is a very large number of people with retirement funds below $5,000, which is certainly not ideal. Why is this the case?
I suspect that it is because people fail to automate their retirement contributions. The best way to avoid this problem and to build a retirement fund over time is by making systematic contributions over the long-term.
Automatic contributions are beneficial from a psychological point of view because we often fail to miss the money we are investing if it is contributed immediately after being received.
Financially, automatic contributions are beneficial, as they allow investor to benefit from dollar cost averaging – investing a fixed dollar amount into the market regardless of the price of the investment. This means we buy more when prices are cheap, and less when they are expensive.
For investors just beginning to contribute to their retirement fund, start by setting up automatic contributions with each paycheck (preferably with an employer match). Increase these contributions over time until they begin you begin to feel stretched, and then decrease them slightly to a level where you feel comfortable.
Investment returns are an important factor in retirement planning during both the accumulation stage and the payout stage. However, estimating future investment returns can be tricky.
Today’s economic environment has many factors that did not exist in the past. Two notable examples are zero interest rate policy (ZIRP) and negative interest rate policy (NIRP).
This has led many investors to wonder if future stock market returns will be dramatically different than they have in the past.
I do not believe this is the case. The stock market has been around for a long, long time and the average returns have not suffered in the current environment.
Source: Yahoo! Finance
As such, I have no problem basing future expectations off of previous market returns as long as returns are viewed with a long time horizon.
The Sure Dividend Retirement Calculator was created using a probabilistic model based on historical returns from the Vanguard Dividend Appreciation ETF (VIG).
Investors could similarly forecast their retirement using returns from other benchmarks. Some of the most common are:
- The S&P 500 Index
- The Dow Jones Industrial Average
- Barclay’s U.S. Aggregate Bond Index
Investors can blend these indices to create a custom benchmark.
For instance, if an investor had a 50/50 allocation to fixed income and domestic equities, then they could forecast their future returns with the historical rates of the S&P 500 and the Barclay’s U.S. Aggregate Bond Index.
One word of caution. It is much better to underestimate future investment returns than to overestimate them. Investors who are basing their retirement planning on 12% portfolio returns have a much higher change of being disappointed than investors who use 7% annual returns.
Balancing realistic expectations with a conservative outlook is a key component to successful retirement planning. The best way to maximize investment returns is by sticking to a quantitative, unbiased system such as The 8 Rules of Dividend Investing.
This prevents emotions from getting in the way of investing.
Once a decision is made to retire, investors are faced with one of two situations.
They can either spend their entire nest egg during their lifetime or leave some left over for loved ones, charitable donations, and other causes.
In either case, investors must still take into account their life expectancy. The potential of running out of money is a frightening thought that worries many investors on the brink of retirement.
There are widely-accessible data surrounding life expectancies for individuals of all ages. While this data is mostly used by actuaries, the diligent investor can use it as a part of their holistic retirement forecasting.
One of the best sources for life expectancy data is the Social Security Administration. This should come as no surprise, as U.S. life expectancy data certainly plays a significant role in the SSA’s forecasting.
The SSA website is full of useful information, including diagrams of these trends over time. As one would expect, life expectancy has been increasing as time passes.
For new retirees, a similar chart exists to estimate life expectancy at age 65.
Right now, newly born Americans have an average life expectancy of ~76 years for men and ~81 years for women. U.S. individuals who have already reached age 65 have a life expectancy ~17 for men and ~20 for women.
This is valuable information and should certainly be incorporated into retirement planning. For a more detailed table of life expectancies, visit the SSA website.
Final Portfolio Size Requirements
Once a retirement date and a reasonable life expectancy has been determined, investors now need to calculate how much income they can expect to generate from their nest egg. This is important because if it seems on the low side, investors can adjust their behavior accordingly by saving more or working longer.
If an investor plans to live on dividends alone, calculating expected retirement income is easy. Simply multiply the value of the retirement portfolio by its dividend yield.
For instance, a $1 million portfolio with a 2.5% dividend yield will generate $25,000 of dividend income each year.
The math behind retirement planning becomes more complex if an investor will be drawing down principal during their retirement years.
While it might be tempting to just divide the value of the nest egg by the number of expected retirement years, this is not accurate because it assumes zero investment returns.
This would only be true if the retirement fund was held in cash.
In reality, a number of variables impact the rate at which investors can or should withdraw money during retirement. These include:
- The number of years they will spend in retirement
- Their expected investment returns
- The size of their investment portfolio at retirement (preferably calculated using the Sure Dividend Retirement Calculator)
One common method that is used to calculate expected retirement income is the 4% rule.
The 4% rule was originally created when a financial advisor named William Bengen performed extensive analysis on historical stock market returns and concluded that if investors withdraw 4% of their retirement portfolio every year, they have a very high probability of their savings lasting them until the end of their retirement.
While rudimentary in nature, the 4% rule is considered a ‘safe’ amount to withdraw every year, especially when composed primarily of dividends. Living on dividends alone during retirement is highly preferable to selling investments over time.
This is because investors who live off dividends will not be adversely impacted when the stock market experiences a temporary downturn. The short-term market price fluctuations of their investments are irrelevant to them as long as their companies continue to grow their dividends.
This growing dividend stream will provide more income and increase yield on cost over time.
It is important to make conservative assumptions about one’s expected financial circumstances at retirement. After all, if one happens to generate more income than expected, this is a pleasant surprise rather than an unexpected complication.
Planning for retirement is complicated.
There are many factors to consider. Not only to investors have to develop (and follow!) an investment plan during their accumulation stage, they also have to realistically estimate their retirement income.
With so many variables, these estimations can seem impossible without the proper tools.
This is why this post introduced the Sure Dividend Retirement Calculator. By providing probability-based simulations of future investment returns, this calculator gives reasonable estimates of an investor’s future portfolio value.
This will help simplify retirement planning for dividend growth investors.